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Answer: Unlike the Merton model that produces default predictions based on asset and liability values, the agencies' rating models produce default predictions from a substantially larger set of business factors.
**B is correct.** The agencies' rating models consider a comprehensive set of factors including: - Country of incorporation and operations (sovereign risk) - Industry profile and competitive environment - Business sector characteristics - And many other business factors **A is incorrect** because Credit Risk Plus (CreditRisk+) does not use the company's capital structure (unlike the KMV model) or credit ratings (unlike the CreditMetrics model). It focuses on default events. **C is incorrect** because KMV models can be used to compute the risk of portfolios that include other payoffs besides pure debt contracts, such as swap contracts and convertible debt. **D is incorrect** because desirable features of rating systems include measurability and verifiability, which means they must be adequately and continuously backtested to ensure they give correct expectations in terms of default probabilities.
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A risk manager at a bank is conducting an internal training program for newly hired credit risk analysts. The manager gives an overview of credit risk models, compares the bank's internal credit rating models to the rating agencies' models, and explains the assumptions, structure, and performance measures of these models as applied to counterparty default prediction. Assuming a stable market environment, which of the following statements would the manager be correct to make?
A
The Credit Risk Plus (CreditRisk+) model relies on the use of a company's capital structure and credit ratings to predict default of the company.
B
Unlike the Merton model that produces default predictions based on asset and liability values, the agencies' rating models produce default predictions from a substantially larger set of business factors.
C
Unlike the agencies' rating models, the KMV model is only used to compute the risk of pure debt contracts and is not applicable to portfolios that include derivatives contracts.
D
A good rating model is expected to provide accurate borrower default predictions without the need to be backtested.